Fiscal and monetary policy


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Fiscal and monetary policy

  1. 1. Introduction The aim of this report is to give some insight into recent, current and forthcoming changes and adjustments in the monetary and fiscal policies of both the EU member countries and the accession countries, particularly from the viewpoint of challenges of the Eastward enlargement of the euro zone. This report tries to summarize a more detailed analysis from the regional inputs to monetary and fiscal policy workpackage, where project’s research partners from both the EU and accession countries provided their country-specific views on most challenging issues of monetary and fiscal policies for individual countries and/or groups of countries in their process of Eastward enlargement of the eurozone. This final report summarizes the results and draws some general conclusions from these regional inputs. Monetary and fiscal policies in the EU countries have been reshaped dramatically in the recent few years in response to the switchover to EMU and introduction of the euro. Transition to the single monetary policy called for a redefinition of national fiscal policies and of the optimal policy mix between monetary and fiscal policy. On the other hand, accession countries are preparing to join the EU in 2004 and the euro area a few years later. This brings new challenges to their current and prospective monetary and fiscal policies. The future Eastward enlargement of the eurozone poses opportunities and risks for both groups of countries and requires adjustments in their monetary and fiscal policies in order to enable a soft landing of accession countries in the euro area. In the area of monetary policy it turned out that reshaping of monetary policies due to challenges of the Eastward enlargement of the eurozone could not be approached in an uniform fashion for both group of countries, EU member countries and accession countries. The common denominator simply could not be found, as both groups of countries are facing different issues, problems and challenges. The focus of monetary policy in the EU countries is different from the one in the accession countries.
  2. 2. Even for the EU countries, obviously there are two groups of countries, EMU countries and those not participating in the euro area, which face different problems with monetary policy. For obvious reasons this report concentrates on EMU countries. The “outs” retain their more or less independent national monetary policies. For them the main challenge is to decide if and when to join the eurozone, therefore for them the issues of the Eastward enlargement of the eurozone seem more remote and thus less relevant for the moment. However, there is an important link between the inclusion of “outs” in the eurozone and the Eastward enlargement of the eurozone. If the introduction of the euro precedes the Eastward enlargement of the eurozone it will be interesting to see whether according to the “same rules principle” actually the same rules and procedures would be applied to both groups of countries, or there would be some exemptions given to current EU “outs” (based on political bargaining and balance of powers) which could not be available for the accession countries. In the EMU countries, the fundamental reshaping of their monetary policies took place with the introduction of the euro, when national monetary policies were given up in favour of a single monetary policy. Centralisation of the monetary policy in the EMU meant that from the viewpoint of monetary policies countries became similar to regional economies instead of national economies. In the process they first had to prepare for the adoption of the euro and fulfil the Maastricht convergence criteria and then had to learn to live in a monetary union by adjusting to possible symmetric and asymmetric shocks without the instruments of national monetary and exchange rate policy.
  3. 3. Inclusion of accession countries in the eurozone will by definition mean additional problems for the single monetary policy, first, by the mere fact that the eurozone will be enlarged (more countries participating), and second, by the fact that it will become more heterogenous. The inclusion of new and somewhat different countries in the eurozone definitely complicates the single monetary policy in the euro area. The accession countries are coming from the transition process and in the process of their preparations for the accession to the EU have not finished all structural reforms which would make their economies more similar to those of the current EU member countries. They are definitely lagging in real convergence (if we take GDP per capita as the usual measure of real convergence) compared to the EU average and are at the moment not fulfilling nominal convergence criteria (Maastricht monetary and fiscal criteria). However, it should be mentioned that that they are not further away from fulfilling the nominal convergence criteria than were some EU countries at comparable time distance before their inclusion in the EMU. Also, inclusion in the EU and in the ERM 2 will for accession countries be a source of a potentially significant asymmetric shock. Definitely, accession countries are somewhat different from the EU member countries. The question remains, however, how relevant this is for the European single monetary policy. Can it be a priori assumed that they will by definition be less inclined to macroeconomic stability and to responsible (conservative) monetary policy? Will they be asking for assistance through various channels of redistribution and transfers which exist in the EU, including political bargaining, in case of asymmetric shocks once in the EMU, thus burdening EU countries with additional costs? Probably it is too soon to give a definitive answer. It might be, however, that the real threat to the smooth functioning of the single monetary policy could come not so much from their needs or wishes for an easier monetary policy in the euro area, but from the weaknesses in their financial sectors and payments systems. In other words, the risks from admitting the accession countries to the eurozone could be more in the implementation than in the stance of the single monetary policy. Dangers of admitting the accession countries to the eurozone for the conduct of the European single monetary policy should not be overemphasised. Their combined share in terms of monetary aggregates or GDP is almost negligible.
  4. 4. Decision-making process in the ECB will have to be adjusted to absorb the accession countries as new coming members of the eurozone. The eurozone membership may increase up to 25 countries till the end of this decade if EU “outs” also decide to join and adopt the euro. This would technically complicate the decision making process in the Governing board of the ECB. Reaching consensus or even letting every member of the board express his position would become extremely difficult. One country one vote principle would have to be adjusted to preserve the existing balance of powers between large and small countries and to prevent some possible “instability coalitions” between some groups of countries. The need for such readjustments is recognised, but alternative technical solutions are still discussed and the final agreement has not been reached so far . European single monetary policy is determined with the view on the EU as a whole, in other words, with a view on the EU (or EMU, to be more precise) average. From individual countries’ point of view it is by definition not optimal. Economic and financial structures, demand for money, transmission mechanisms of monetary policy and phases of economic cycles differ among individual member countries. The main refinancing interest rate of the ECB is too high for countries in a recession and too low for countries going through an expansionary phase of the cycle. There is no such thing as a “European cycle” which would make the formulation of the single monetary policy much easier. Anyway, this is a situation well known between different regions within a country. Inclusion of the accession countries in the eurozone will increase the size of this problem, particularly if their economic cycles are less synchronised with the EU average.
  5. 5. The risks of Eastward enlargement of the eurozone for the single monetary policy therefore derive not only from non-synchronised economic cycles in the accession countries, but also more generally from their exposure to asymmetric shocks (or even from differing responses to symmetric shocks as a result of differing transmission mechanisms) and from their ability to activate alternative mechanisms of adjustment which can absorb these shocks in the framework of the EMU. There are some safeguard mechanisms prepared for the accession countries in their run up to the eurozone: coordination and surveillance of their economic policies after their EU accession, participation in the ERM 2 in the interim period before the adoption of the euro, compliance with the nominal convergence criteria and with real convergence requirements. These safeguard mechanisms should enable soft landing of the accession countries in the EMU. The problems for the single monetary policy from the Eastward enlargement of the eurozone would in this case be more of a quantitative nature (up to 25 countries, more heterogeneity be definition) than of a qualitative nature (inclusion of “problematic” member countries). The final outcome depends on successful preparations, and, last but not least, on the optimal timing of the inclusion of the accession countries in the eurozone. As far as the accession countries are concerned, they have for the moment full monetary sovereignty, at least formally, and can lead independent monetary policies. Factually, independence of their monetary policies is constrained by the progress in the liberalisation of their capital flows and is dependent on their choice of the exchange rate regimes. In the process of adopting the acquis communautaire the accession countries committed themselves to liberalise capital flows completely by the time of their EU accession (exemptions and transitional periods required and granted were insignificant), but have already by now eliminated practically all capital controls. There is also a link between the exchange rate regime and the autonomy of the monetary policy. Those accession countries which are relying on fixed exchange rates, particularly on hard pegs like currency boards, have tied hands in monetary policy. On the other hand, those accession countries which opted for floating exchange rate regimes, particularly free floaters with inflation targeting, retain independence in their monetary policies, while those relying on intermediate regimes, such as managed floating, are somewhere in between.
  6. 6. Monetary policies of the accession countries will change with their inclusion in the EU. Their economic policies, including monetary and exchange rate policies, will become a matter of common concern, subject to coordination and surveillance within the EU. It is expected they will join ERM 2 rather soon after their EU accession. Participation in ERM 2 will shift the focus of their monetary policies which will retain some flexibility, but will be oriented to preserving the exchange rate stability required in ERM 2 framework in order to fulfil the Maastricht convergence criterion on exchange rate stability. As ERM 2 is an intermediate soft peg exchange rate regime whose rules, procedures and interpretations are for the moment not defined precisely enough, accession countries perceive it as a potentially dangerous mechanism which can lead to speculative attacks and currency crisis and not necessarily to a soft landing in the eurozone. Their strategies seem to be to stay in ERM 2 as short as possible, for two years only, as is the required minimum period of participation to demonstrate the exchange rate stabilitybefore the adoption of the euro. In line with their ambitions for an early inclusion in the eurozone they also seem to favour an early entry in ERM 2, although this is not a riskless strategy At this moment monetary policies of the accession countries are focused on preparations for meeting the Maastricht convergence criteria, as the time is running out fast. In the recent period the process of disinflation has been rather successful in most of the accession countries. In those where the inflation rates are still rather high, lowering of the inflation rate is the priority of their monetary and other economic policies. The question remains whether the results in disinflation are sustainable, as most of the accession countries register some serious underlying macroeconomic imbalances (fiscal disequilibrium, balance of payments disequilibrium) of substantial proportions. Monetary policy alone may not be enough, coordination of macroeconomic policies is required for the fulfilment of the Maastricht convergence criteria on a healthy and sustainable basis, which can then lead to a soft landing in ERM 2 and to an early inclusion in the eurozone. Monetary policies of the accession countries will in the interim period have to deal with the challenges of capital flows, Balassa-Samuelson effects of real exchange rate appreciation and tasks of achieving nominal and real convergence in parallel.
  7. 7. Their readiness for the inclusion in the eurozone can be approached in terms of their nominal convergence, real convergence and optimum currency area criteria. Optimal timing of the Eastward enlargement of the eurozone and its success will depend on the readiness of the accession countries to adopt the euro, which is dependent on their exposure to asymmetric shocks and on the flexibility of alternative mechanisms of adjustment they can activate and thus compensate for the loss of monetary and exchange rate policy once in the monetary union. Contrary to the situation with respect to monetary policy, issues in fiscal policy are basically the same or at least similar for both groups of countries, EU member countries and accession countries, although its objectives and tasks may differ somewhat and although fiscal policy in both groups of countries is for the moment subject to a different set of rules. For both groups of countries, regardless of the differences, key words are the same: fiscal discipline, fiscal consolidation and fiscal sustainability. The common denominator is that various tasks of fiscal policies in both countries have to be performed within the sustainability framework given by the common EU rules. The link between the Eastward enlargement of the eurozone and fiscal policy is less clear and direct than in the case of monetary policy. In the EU countries reshaping of fiscal policies resulted mainly from redefining the role of national fiscal policies after the centralisation of monetary policy and transition to the single monetary policy, and, presently, is determined by the obligation to keep the fiscal policies within the limits of the Stability and growth pact (SGP). Inclusion of the accession countries in the EU will mean additional fiscal costs to which EU budget and accordingly national fiscal policies of the EU countries will have to adjust. However, inclusion of the accession countries in the eurozone per se will not represent an additional fiscal burden for the EU member countries, at least not directly. However, there are risks of indirect fiscal costs and redistributions which may occur through various possible mechanisms and channels, in case if accession countries meet serious problems once in the eurozone which the EU countries would be willing to finance or in the final instance would have to finance.
  8. 8. In the EU countries (in fact throughout this text we have in mind EMU countries in particular) fiscal policy had to be redefined as a response to the transition to EMU. The first issue is should there also be, in parallel to the single monetary policy, a “single fiscal policy”, centralisation of national fiscal policies at the EU level. From the point of view of finding an optimal policy mix for the EU economy this at first sight might seem as a sound idea. However, while there are some economic arguments to support an EU-wide fiscal policy, this remains an academic idea. Political realities in the EU are such that countries want to retain their fiscal responsibilities. EU budget is, compared to the similar federal states, very limited in size and inflexible, since most of the expenditures are devoted to agriculture and structural policies, so that the EU budget can not support the roles of the EU-wide fiscal policy. Instead of centralisation of fiscal policies in the EU, the concept of co-ordination or harmonisation of national fiscal policies was adopted. The responsibility for the fiscal policy remains at the national level. From the point of view of EU member countries, giving up their national monetary policies should in principle result in more flexibility of their national fiscal policies, merely to compensate for the loss of an instrument of macroeconomic management (adjustment mechanism). However, there are important externalities, spillovers from national fiscal policies, related to their unsustainable fiscal position (excessive fiscal deficits leading to unsustainable debt dynamics), which can harm other member countries and in the final instance also the quality of the single monetary policy. Therefore, national fiscal policies have to be co-ordinated or harmonised, in other words constrained by the common EU rules. This was the approach adopted for the EMU. National fiscal policies remain independent, but severely restrained by the EU-determined rules.These fiscal rules are first and in the most general manner determined in the Treaty (TEU) in the form of excessive deficit rules and procedures. More concretely, they are defined as the fiscal part of the Maastricht convergence criteria (budgetary deficit, public debt) as a precondition in qualifying for EMU membership. And finally, later on, provisions of Growth and Stability Pact (GSP) were defined so as to protect the sustainability of public finance also after inclusion in EMU.
  9. 9. SGP defines general fiscal rules of TEU more concretely, in terms of procedures, including sanctions for non- compliance. EMU countries after joining the eurozone have to comply with SGP rules. In their stability reports they have to present their current fiscal situation and explain how they plan to sustain their fiscal position in terms of compliance with SGP rules in the medium-term. SGP basically limits public finance deficit (for practical reasons in the following we use the term budgetary deficit as a shortcut approximation) to maximum 3% of GDP annually, except in the case of a precisely defined severe downturn in economic activity. However, in the medium-term the budget should be balanced or even in surplus. Other elements of SGP are rules and procedures, such as on detection of the problem, on early warning system, on the timing of the elimination of the problem and on sanctions if the problem is not eliminated in time.The idea is that in normal times budgetary deficits should be close to zero, so that in bad times countries can afford more expansionary fiscal policy and increase their budgetary deficits up to 3% of GDP (but not above this benchmark, except in severe recessions). Ideally, in the medium term the budgets should be balanced, while within economic cycles they should move according to the phases of the cycles from surpluses to deficits, but within the 3% budgetary deficit limit of SGP. Obviously, the idea is that fiscal policy within the cycle should primarily reflect the working of built-in or automatic stabilisers of the fiscal policy (increase of public spending such as unemployment benefits and/or decrease of collected taxes in times of recession, and vice versa in times of booming economic activity). The functioning of such automatic fiscal stabilisers within the cycles itself contributes to stabilising the economy. More discretionary or activist fiscal policies are subject to much scepticism anyway, as there are problems with timing and tine tuning of such fiscal measures, since various lags are operating here. There was considerable fiscal consolidation in the run-up to the EMU in the EU countries in the nineties. Among different strategies of fiscal consolidation more successful and sustainable proved to be those which relied on public expenditures cutting. However, some of the EMU countries remained close to their limits of budgetary deficits of 3% of GDP.
  10. 10. Part A: Fiscal policy Introduction On May 1st , 2004, ten new countries are going to accede to the European Union. This will be the milestone in integration of Central and Eastern European Countries with the economically developed Europe, but not the end of this process. In a few years time, the accession of these countries into the Economic and Monetary Union can be expected, which will pose a great challenge as well. There are numerous dimensions in which this process should be analyzed, however, this particular report will concentrate on such an important, and still only to a certain extent coordinated, issue as fiscal policy. In relation to the Eastward Enlargement of the Eurozone, it is crucial to take into account the experiences of current EMU Member States, the fiscal stances in candidate countries, together with their development perspectives, as well as the Community influence on shaping national fiscal policies. All these subjects will tackled in this report. 1. Fiscal situation and middle-term perspectives in EMU Member States Fiscal situation and its development over the recent years in current EMU Member States was closely related with the requirements of Economic and Monetary Union. Therefore, it is important to elaborate on the fiscal criteria in order to understand the factors which were influencing shaping of fiscal policy in these countries, as well as challenges which await states eager to join the EMU in the future. The rationale behind EMU fiscal rules One of the vital features of the institutional framework of the EMU is strong fiscal discipline, which is necessary to support the independent monetary authority European Central Bank (ECB) in its mandate of preserving price stability. The authors of the Treaty were particularly concerned about preventing a repeat of fiscal policy failures, which occurred in Europe in the 1970s and 1980s (Buti and Giudice, 2002)
  11. 11. . These years were an era of rapidly rising share of the general government sector in the economy. In countries belonging to the euro area, the relation of government expenditures to GDP had risen from 36% in 1970 to a high of over 52% in 1993 (European Commission, 2000). Government revenues also increased very significantly during that time, but not quite as fast as spending. As a result, net borrowing of euro area countries grew from almost nil in 1970 to a range of 4-5% in the 1980s. This had inevitably resulted in a quickly rising stock of public debt, which in late 1970s totaled less than 30% of GDP, but by early 1990s its relation to GDP had more than doubled. Growing debt had in turn fuelled a further rise in expenditure in the form of interest payments, which by 1990 amounted to around 4% of GDP. To make matters worse, fiscal policy in Europe in the 1970s and 1980s has tended to be pro-cyclical. This means that government budgets did not help to dampen cyclical fluctuations of the economy as they could and should have, but instead have contributed to amplifying output swings. The budget should be anti-cyclical primarily through the working of automatic stabilizers. In a situation of a cyclical downturn, tax revenues are lower, while unemployment- related and social spending tends to be higher, resulting in a higher deficit and helping the economy come out of recession. Meanwhile, during an upturn, tax revenues are buoyant, fewer citizens require social assistance of the state and the deficit is thus automatically reduced. However, this was not the case in the period in question. Deficits did not fall as expected during
  12. 12. economic upturns, implying that rather than allow for automatic stabilizers to work, policymakers opted for tax cuts or spending increases in periods of boom. This has in turn forced them to tighten fiscal policy in times of recession, as they could not let the deficit and public debt rise indefinitely. There are two main conclusions to be drawn from these developments, which imply that a radical change in fiscal policy was required. The first one is that policies carried out in the 1970s and 1980s were simply unsustainable, as evidenced by the rapid growth of public debt. The second is that such pro-cyclical policies would have been much more dangerous in a monetary union, where an excessively lax fiscal policy stance in one country cannot be countered by restrictive monetary policy, which is the same for all countries. Similarly, if one country conducted a restrictive fiscal policy during a downturn, because its public debt had risen to extremely high levels already, a single monetary authority could not focus on reviving the economy of that one particular country. The fiscal criteria of Economic and Monetary Union The fiscal story of the 1970s and 1980s, outlined above, was an important factor in the design of the rather rigid fiscal framework of the Maastricht Treaty and, consequently, the Stability and Growth Pact, which is meant to ensure fiscal prudence within the Eurozone. There are two basic types of fiscal rules, which can help enforce
  13. 13. fiscal discipline (Buti and Giudice, 2002): a) Numerical targets, namely explicit constraints on fiscal variables, such as spending, deficit and debt or their growth b) Procedural measures conducive to formulation of disciplined fiscal policy Numerical targets are simple to implement and monitor, provided there are good fiscal accounting standards. The drawback of tight numerical rules is that they enforce strict discipline also during economic downturns, which can lead to pro-cyclical fiscal policy, if policymakers are not prudent enough to lower the deficit during a boom. A possible solution to this problem would be using numerical targets for structural budget balances, but this is methodologically difficult, as it would involve a numerical target based on an unobservable variable – the output gap. Another important drawback of numerical targets is that they encourage using one-off measures or even creative accounting measures in order to attain the right figure on paper. Such measures are not conducive to prudent fiscal policy and thus do not comply with the objectives which fiscal rules are supposed to achieve in the first place. As shown later on in this discussion, such measures were in fact employed by some EMU candidates to attain an illusory improvement in their fiscal position. Procedural measures are aimed at creating “hierarchical” budgeting procedures, in which the supreme fiscal authority has strong power to maintain spending limits set. At supra-national level, a supra-national body is assigned the power to assess the fiscal position of national governments and
  14. 14. sanction them for failure to meet numerical targets. The institutional framework of the Maastricht Treaty is a combination of numerical and procedural measures. On one hand, the Treaty stipulates that Member States shall attain a high degree of sustainable convergence in order to be admitted to a monetary union. One of the elements of this convergence is sustainability of the government financial position, specified as a deficit below 3% of GDP and public debt not higher than 60% or in case of higher debt, it should be approaching the reference value at a satisfactory pace. Fiscal problems and policy reforms in the chosen EMU countries The Maastricht Treaty was a powerful stimulus for European Union countries to consolidate their budgets. The role of the Treaty and the ‘carrot’ of future EMU membership is particularly evident, when considering the unfavorable economic climate of the early 1990s in spite of which a remarkable fiscal consolidation has been achieved (European Commission, 2000). All 11 future members of the EMU,1 had embarked on a fiscal consolidation path, although for example Ireland need not have done so, since it had already reduced its budget deficit significantly in the late 1980s. This means that there are at least 11 interesting cases of fiscal retrenchment to analyze. Considering that each of these 11 countries began its consolidation process from a different starting point, in a different economic and political setting, there is no surprise in the fact that they have pursued very diverse strategies. There are different ways of classifying these strategies, with the most common division being that into revenue- and expenditure-based retrenchment strategies. The European Commission distinguished also a third path – the
  15. 15. “switching’ strategy in which countries first resort to revenue adjustments and then switch to expenditure cuts. However, another classification can be offered, one which relates to the numerical nature of Maastricht Treaty targets. As mentioned earlier, these can also be attained through superficial measures. We would therefore propose to divide the consolidation strategies into three groups: - expenditure- based consolidations, - revenue- based consolidati ons, - mixed strategies featuring one-off measures and, in some cases, creative accounting. Austria Following the failure of Austria’s first EMU-aimed budgetary retrenchment effort in 1995, when the deficit turned out at 5,1% of GDP, a comprehensive reform package was introduced in the following year. Consolidation measures were introduced for most categories of revenues and expenditure, however, the bulk of the adjustment occurred on the spending side. Expenditure decreased by 2,8 percentage points of GDP between 1994 and 1997. The cuts were focused in such areas as public administration wages, family allowances, other welfare transfer payments, unemployment benefits, subsidies to the business sector, reduction of health care costs. Furthermore, early retirement options were restricted. In spite of the need to reduce the deficit within a short period of time, the Austrian government implemented several systemic measures, rather than resorting to temporary tax increases or spending cuts. Taxes were also adjusted, through elimination of some concessions and allowances, mainly in the area of direct taxes. These measures allowed Austria to lower its deficit to 1,7% in 1997,
  16. 16. comfortably meeting the Maastricht deficit criterion.
  17. 17. Finland At the beginning of the 1990s, Finland was undergoing quite pronounced economic difficulties, caused by the breakdown of trade with the former Soviet Union and a banking crisis. As a result, the country ran a high budget deficit, exceeding 5% of GDP. However, in 1995 a determined fiscal consolidation strategy was implemented, leading to quick reduction of the deficit in subsequent years and achievement of a budget surplus in 1998. This strategy involved radical measures on the expenditure side, as public spending decreased by 12 percentage points between 1992 and 1999. The government undertook firm measures to lower social transfers and intergovernmental transfers. The pension system had undergone a comprehensive overhaul, including lowering accrual factors, less favorable calculation of pensionable wage and lower indexation. Access to unemployment benefits was tightened and the policy of subsidizing industries altered. Thanks to such extensive measures on the expenditure side of the budget, the government was able to not only attain a budget surplus, but also to lower social security contributions, with the aim of promoting employment. Ireland The “Irish miracle” is a well-established phrase in economic literature, which says a lot about Ireland’s macroeconomic performance over the past two decades. The country has achieved a spectacular turnaround by implementing a host of bold structural reforms, one of which was a major overhaul of public expenditure, conducted already back in the 1980s. This made Ireland the only EU country meeting the Maastricht fiscal deficit criterion on the day the Treaty was signed. However, prior to its spending reforms, Ireland’s fiscal policy was very lax and public debt soared to levels in excess of 100% of GDP. The government was therefore intent on maintaining prudent fiscal policy, so as to facilitate a steady reduction of the debt level, while at the same promoting employment. At the beginning of the 1990s, additional fiscal adjustment took place, but this time on the revenue side of the budget, primarily through broadening of the corporate tax rate. However, between 1994 and 1999 public spending was further lowered by 5,9 percentage points of GDP. This was attained thanks to a reduction in wage compensation of public employees, agreed with trade unions, as well as lower transfers. As a result, Ireland attained a budget surplus of 2% of GDP in 1999, while reducing its debt level to 43,9%, half of what it was barely five years earlier.
  18. 18. The table below shows the remarkable improvement in the budget balances of the 11 members of the EMU. Table 1. Budget balances (in % of GDP) of EMU countries in the 1990s 1993 1994 1995 1996 1997 1998 Austria -4,2 -4,8 -5,1 -3,8 -1,7 -2,3 Belgium -7,3 -5,0 -4,3 -3,8 -1,9 -0,9 Finland -7,3 -5,7 -3,7 -3,2 -1,5 1,3 France -6,0 -5,5 -5,5 -4,1 -3,0 -2,7 Germany -3,1 -2,4 -3,3 -3,4 -2,7 -2,1 Greece -13,8 -10,0 -10,2 -7,4 -4,0 -2,5 Ireland -2,3 -1,7 -2,2 -0,2 0,7 2,1 Italy -9,4 -9,1 -7,6 -7,1 -2,7 -2,8 Netherlands -3,1 -3,6 -4,2 -1,8 -1,1 -0,7 Portugal -6,1 -6,0 -4,6 -4,0 -2,6 -1,9 Spain -6,7 -6,1 -7,0 -4,9 -3,2 -2,6 Source: IMF World Economic Outlook, 2001 The Maastricht Treaty turned out to be a very effective impulse leading to successful reversal of the 25-year deterioration in the public finances of EU countries. The deficit of the euro area fell by 3,5 percentage points of GDP between 1993 and 1997 to reach a level below the 3% of GDP threshold. Was this a sufficient adjustment? It may appear so considering that all countries except for Greece, attained a deficit below 3% of GDP in 1997. This means that EMU countries consolidated their budgets sufficiently to enter the EMU. Nevertheless, the results do not reveal the whole information on how they were achieved. Four different methods were possible. First, increasing revenues by increasing taxes (direct or indirect). Second, increasing revenues by liberalizing fiscal policy, i.e. reducing both personal income tax and corporate income tax and thus increasing revenues by entrepreneurship growth. Third, by reducing expenditures. Another method could contain a mixed approach with reducing taxes and cutting expenditures. The latter three methods were effective and resulted in sustainable solving of the problem, while first of them proved a temporary measure.
  19. 19. As far as the level of public debt is concerned, only few countries managed to achieve the required value, however, the Commission treated this criterion more flexibly due to the possibility of “approaching the reference level at satisfactory pace”, and qualified all countries fulfilling the remaining criteria. Table 2. presents the levels of public debt in 1997 (which was the reference year for fiscal criteria) in countries qualified for joining the EMU. Table 2. The level of public debt in EMU countries in 1997 Country Public debt (in % of GDP) Luxembourg Finland France Germany Portugal Austria Ireland Spain Netherlands Italy Belgium 6,7 55,8 58,0 61,3 62,0 66,1 66,3 68,8 72,1 121,6 122,2 Source: L. Oręziak, Euro: nowy pieniądz, Wydawnictwo Naukowe PWN, Warszawa 1999, pg. 44 However, it is important to note that after EMU candidates meet the entrance criteria and join the Union, they need to continue to maintain fiscal discipline. In fact, they are bound by even stricter rules of the Stability and Growth Pact (SGP). The Pact was adopted by the European Council in 1997 as a means of ensuring budgetary discipline inside of the EMU. It includes measures to strengthen surveillance of budgetary positions as well as detailed regulations on the excessive deficit procedure of the Maastricht Treaty. Moreover, as far as the numerical target for the deficit is concerned, the SGP constitutes a very important interpretation of the Maastricht reference
  20. 20. criterion. The Pact states that Member States should achieve a medium-term budget position “close to balance or in surplus.” This is crucially important, because it means that the 3% of GDP limit is not a target, but an absolute ceiling, which may not be violated, except for exceptional situations. The SGP therefore imposes the following fiscal strategy on Member States: their budgets should be close to balance or in surplus when their economies grow at the trend rate. This would ensure, that the deficit does not breach the 3% of GDP level during normal cyclical downturns. However, there seems to be one flow in this design. All countries are generally permitted to have a budget deficit of up to 3%. Due to this such level of deficit may also be maintained during the economic upturns. However, when recession comes there is no room for movement, as the deficit is already close to the set ceiling. Due to this there is a question whether SGP should not be reshaped in such a way that it imposes more balanced budget, and only during economic slowdown the government would be permitted to raise the deficit slightly. This would especially useful when the aim of constant reduction of public dept is concerned, as its decrease over a year’s period can only be achieved if it is paid back at a pace exceeding the average interest rate of the public debt. Therefore, in the situation when the current interest rate is lower then the average interest rate of the debt, it is profitable to increase deficit in order to pay back more debt, as this lowers the debt’s servicing costs. It thus appears, that what really matters for fiscal stabilization is the primary budget situation, excluding the debt servicing costs. Due to this it also seems sensible to treat the primary budget balance more stringently, while allowing some more room for deficit by which the public debt is being reduced. It is especially significant in the situation of countries with over 100% of GDP worth of public debt, in which reduction of public debt seems to be one of key economic goals in order to decrease payments in the future.
  21. 21. Aside from an economic downturn which could undermine the newly improved budgetary positions of EMU countries, another key issue is the quality of the consolidation strategies. For example, if an adjustment is attained through short-lived measures such as introduction of special temporary taxes or suspension of indexation of public sector wages for one or two years, the budget position is likely to deteriorate after these measures are revoked. Therefore, it is important to look at the quality of the fiscal adjustment achieved in EMU countries. Results of fiscal consolidation in EMU countries The fiscal position of EMU countries in the years following their consolidation effort is a telling indicator of the quality of the fiscal adjustment. The fiscal imbalance of most euro area countries deteriorated between 1998 and 2002 and in some cases it is expected to deteriorate further by 2004. To some extent, this is due to negative cyclical developments. However, those countries which have consolidated their budgets to reach a position close to balance or in surplus in the late 1990s, shall have no problem maintaining their deficit within the 3% of GDP limit, even during an economic downturn.
  22. 22. Let us examine the fiscal situation in EMU countries, divided into the same three groups as above – according to their consolidation strategies. Table 3. Post-consolidation budget balances (in % of GDP) of countries which pursued expenditure-based retrenchment strategies 1998 1999 2000 2001 2002 2003 2004 Austria -2,4 -2,0 -1,5 0,1 -0,6 -1,1 -0,4 Finland 1,3 2,3 6,7 5,1 4,7 3,3 3,0 Ireland 2,1 2,0 2,4 1,2 -0,3 -0,6 -0,9 Netherlands -0,8 0,5 1,3 0,2 -1,1 -1,6 -2,4 Spain -2,5 -1,1 -0,4 0,0 -0,1 -0,4 -0,1 Source: European Commission (2000, 2001, 2002, 2003) Note: excluding UMTS revenues As the above table shows, the improvement of fiscal positions in this group of countries appears to be quite permanent. In 2001 none of the countries from the group recorded a public finance deficit. In the following years their balances have deteriorated somewhat
  23. 23. due to the economic downturn, however, none of them has, or is expected to breach the 3% of GDP reference value for the deficit. Table 4. Post-consolidation budget balances (in % of GDP) of countries which pursued revenue-based retrenchment strategies 1998 1999 2000 2001 2002 2003 2004 Belgium -1,1 -0,9 0,0 0,2 0,1 -0,2 -0,1 Greece -2,5 -1,8 -0,8 -0,4 -1,2 -1,1 -1,0 Portugal -2,1 -2,0 -1,7 -4,2 -2,7 -3,5 -3,2 Source: European Commission (2000, 2001, 2002, 2003), OECD Economic Outlook (for Greece in 1998- 2000 period) Note: excluding UMTS revenues The fiscal situation in this group of countries is diverse. Belgium and Greece continued to reduce their deficits following the pre-EMU consolidation period and are expected to maintain low deficits until 2004. Meanwhile, Portugal’s fiscal balance slipped considerably in 2001. Although the deficit was initially forecasted to be under 3% in that year, it actually turned out above 4%. Portugal quickly took measures, partly of one-off nature, to reduce it in the following year, but according to European Commission forecasts, the situation was not fixed permanently and further problems are expected in 2003 and 2004. It is worth pointing out, that while all of these countries relied mainly on raising revenues to lower their deficit in the 1990s, their behavior on the expenditure side differed. Belgium supported its consolidation effort by a moderate cut in spending. Greece allowed its expenditure to rise, but only by a modest 2 percentage points between 1989 and 1999. Meanwhile, Portugal’s public spending grew by well over 5 percentage points between 1991 and 1998. This could help explain why the consolidation effort of that country proved to be insufficient to permanently keep the deficit under 3% of GDP.
  24. 24. The present fiscal picture of this group of countries is the most troubling. All three countries are expected to breach the Maastricht deficit criterion at some point in the 2002-2004 period. This casts a doubt over the quality of their adjustment effort. Table 5. Post-consolidation budget balances (in % of GDP) of countries which pursued mixed retrenchment strategies, including one-off measures and creative accounting 1998 1999 2000 2001 2002 2003 2004 France -2,7 -1,8 -1,4 -1,5 -3,1 -3,7 -3,5 Germany -1,8 -1,1 -1,0 -2,7 -3,6 -3,4 -2,9 Italy -2,8 -1,9 -1,5 -2,6 -2,3 -2,3 -3,1 Source: European Commission (2000, 2001, 2002, 2003) Note: excluding UMTS revenues 2. Fiscal position and its middle-term perspectives in candidate countries Having described the evolution of fiscal stance of current EMU Member States in the period of adjustment to the Maastricht fiscal criteria, as well as after the accession to the Eurozone, we should analyze the current fiscal position of candidate countries in order to conclude on the perspectives of them fulfilling the criteria in the next few years. It is important to identify the main problems, as well as evaluate the consolidation programs which governments of these countries are going to implement.
  25. 25. Current fiscal position in candidate countries The budgetary situation in the accession countries shows significant differences. Deficit ratios to GDP vary between a balanced budget (Estonia) and a considerable deficit (Hungary, the Czech Republic). But still some general observations can be made and similarities found. This is particularly true for the group of four Central European countries – Czech Republic, Hungary, Poland and Slovakia, which had the highest deficits in 2001. The budgets of these countries are characterized by a high proportion of so-called mandatory expenditure, for example on pensions and social benefits, which means that they are inflexible and difficult to reform. As a result, efforts to reduce expenditure in those countries were not sufficient to attain low deficits. Together with country-specific problems such as costs of restructuring of the banking sector (most notably in Slovakia and Czech Republic), a pronounced economic slowdown (Poland) and political pressures to increase spending (Hungary), this has led to high deficits in those countries in 2001. Slovenia has also had to deal with the problem of high level of fixed spending in the budget, but its overall fiscal stance had been tighter than that of the four Central European accession countries. Moreover, the phase of buoyant growth in recent years was not used for reducing deficit to GDP ratios in the Central Europe. In fact, deficits in most Central European countries were unchanged or on the rise in the period implying that the positive cyclical impact was offset or even overcompensated by a worsening of structural balances. This contrasts with the developments in the Baltic countries. The Baltic countries faced a rapid increase in deficit ratios in 1999 attributable to the shock caused by the Russian crisis. Although the Russian crisis led to economic slowdown, fiscal positions were brought under control very quickly as growth re-gained momentum. Whereas the Central European countries followed obviously a pro-cyclical fiscal stance, this has not been the case for the Baltic countries, although the fiscal positions of Latvia and Lithuania could be facing pressures of planned tax and pension reforms, both causing deterioration of the budget balance in the short-term.
  26. 26. In sum, two types of policies, which explain the increase in budgetary deficits, were applied in these countries. First, additional cost appeared due to the second phase of budgetary reforms, which in medium term should bring some relaxation to the public finances. Second, these were pro-cyclical expenses, which are a doubtful remedy for the economic slowdown and problems with public finances. On the other hand, current public debt levels in the candidate countries depend very much on initial levels. The countries which started with high debt levels (41,8% in Poland in 2002) are still heavily indebted. On the other hand, the countries with a low level at the beginning of transformation have kept a lower indebtedness (in Latvia, for example, it is only around 16%). In some countries, however, notably in the Czech Republic, debt ratios started to rise. Nevertheless, none of the countries in question is seriously threatened with surpassing the reference value of 60% of GDP. 2005 4,98 2,70 2,27 2006 6,80 2,89 3,91 Source: Ministry of Finance estimations. Also some remarks are needed at this point. Resources for cofinancing the projects can be obtained not only from the national budget, but also from a public-private partnership, which actually lowers budgetary expenses in this respect. In the future there is a possibility of renationalisation of regional policy, which would than increase the costs of membership. If such decision is taken, direct transfers could be replaced by FDI, which is a more effective and less costly solution. Moreover, some EU financial instruments require that a payment is made primarily from national sources and later, after obtaining approval from an eligible EU institution, is reimbursed to the country. Such a mechanism, characteristic of the Common Agricultural Policy, could pose an additional pressure on the central budget in the first years of the EU membership.
  27. 27. Part B: Monetary policy 1. Introduction The recent developments in monetary economics jointly with the issue of Accession Countries to European Union, brings to discuss a very important issue, related with the role of monetary policy in both transition and advanced economies. We have seen a recent explosion of papers working on monetary policy: all of them aim to evaluate and discuss a specific aspect linked to monetary policy rule. In general, the focus of such rules is about an instrument rate where the short term nominal interest rate is set as to react to other variables, typically assumed to be the inflation rate and the level of output (or output gap). The example of such simple feedback rule is the famous Taylor rule. All the recent research had the scope of examining the performance of such simple instrument rules to discuss whether such rule are a good representation of central bank behavior. We can briefly summarize the results from such research by focusing on three distinct aspects: 1) it is better to respond to the determinant of the target variables rather than to target themselves. Under this view, it appears to be good to target both inflation and output, since output is the determinant of the inflation rate). 2) it is absolutely desirable to have history dependence in such targeting rule, because such approach will help to affect the expectation formations of the private sector. 3) Taylor principle and determinacy: in order to get a determinacy equilibrium we need that the coefficient on inflation targeting is bigger than one. A crucial question is to understand under which conditions we can say that Taylor rules are robust. And what should be the policy rule followed by a central bank. The first answer to this question is very simple: if the Taylor rule is the rule we are looking for, then the central bank should mechanically follow it, by targeting inflation and output in a fashionable way.
  28. 28. Therefore, a full commitment to an instrument rule is not fully desirable. In some sense, some deviations from the simple Taylor principle is desirable, but at the current state of the art we do not have any prescriptions about the type of rules that should be followed when the instrument are appropriate. Thus flexibility in implementing such rules is good, but how much flexibility we need? Moreover, central banks have elaborated a complex set of data collection that if implemented can help to result in an appropriate forecasting horizon. The question we need to ask is whether such operation conduct has been fruitful especially for the Accession countries. Moreover, we need also to ask what has to be done in order to improve the ability of the central bank of transition economies to improve their performance in the monetary policy conduct. The present paper is articulated as follows: in the next section I will discuss general features of the monetary policy targeting in accession countries. In the following section I will examine the specific experience of Czech Republic, Poland and Hungary, respectively. In a separate section are collected some considerations about the technicalities of the infaltio ntargeting regime and the possible ways of reform. A final section concludes. 2. Monetary Policy in Accession Countries The recent assessment about the entry into the Euro area by Accession countries poses new challenges in the conduct of monetary policy for the European Central Bank. In particular, the newcomers will have to experience a two-year transition period where their exchange rate is fixed against the Euro. The role of the exchange rate combined with monetary policy appears to be crucial for such countries which have experienced a wide spectrum of exchange rate regime and monetary policy regime since the complete liberalization phase, ranging from the currency board to managed float.
  29. 29. The E-zone accession countries include: Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovak Republic and Slovenia. The monetary history of all these countries is characterized by a wide spectrum of exchange rate regime constantly evolving over time, according to the need to balance exchange rate stability with the control of the inflation rate. In the current situation, three countries adopted an inflation targeting regime: Czech Republic, Hungary and Poland. Two countries experienced a currency board regime: Estonia and Lithuania. Two countries adopted a managed floating regime: Slovak Republic and Slovenia. Finally, Latvia adopted a flexible exchange regime. In particular, as it will be discussed later, the adoption of inflation targeting regime for Czech Republic, Hungary and Poland has been motivated by the need to control both the inflation rate and the exchange rate after currency turbulence of the past years. In this paper I am going to present a preliminary assessment of the inflation targeting policies for Czech Republic, Hungary and Poland, stressing also the possible way to reform the conduct of their respective central bank, by using also the results from the recent development in the literature on monetary policy rules elaborated by Svensson (2003) and Svensson and Woodford (2003). A key element defining the change in monetary policy targeting regime in Eastern European Countries is represented by implementation of a Flexible Exchange Rate peg in place of a Fixed Exchange rate regime. Thus, as described by Mishkin (2000), the issue of inflation targeting has to be strictly analyzed together with the role of exchange rate targeting regime. This aspect is even more important if we consider the fact that immediately after the joining of EMU the Accession countries will experience a fixed exchange rate period against the Euro. This is a potentially dangerous period, because it might originate balance of payment crisis, if the international financial markets will realize that the economic fundamentals of such economies are not in line with what they are expected to be.
  30. 30. During the change in the exchange rate regime, a key fact has been represented by the change in the operating procedure adopted by a large part of accession countries, mainly characterized towards an inflation targeting procedure, in place of monetary aggregate targeting. The topics of the present paper regards an analysis of the efficacy of the inflation targeting procedure adopted by accession countries during the transition to European Monetary Union. Let us start by saying that a monetary aggregate targeting regime is not an appealing monetary policy regime for transition economies. This is because of weak link existing between money supply and price level, because of the presence of a large set of administered prices. The question we need to answer in the following pages is if the inflation targeting procedures adopted by accession countries have been really effective in bringing down the inflation rate and favoring the convergence process. The inflation targeting regime has several advantages over the monetary targeting or currency board solution. The first advantage, in fact, is that in order to have a key element for success for such policy initiative, we do not need a strong stable relationship between money and inflation. A second advantage is given by the accountability of such regime and the fact that it is clearly understood by the public and it is easily to be implemented. In fact, the setting up of a specific targeting rule enables a judgment on actions implemented by the Central Bank, based on objective information, not subjective. As discussed by Mishkin (2000) and Jonas and Mishkin (2003), we can identify six key elements of requirements necessary to make inflation targeting procedure fully successful. Such requirements are: (i) strong fiscal position; (ii) a well understood transmission mechanism between monetary policy and inflation; (iii) Central Bank independence; (iv) a well developed financial system; (v) ability of forecast the inflation rate; (vi) absence of any other nominal targets.
  31. 31. In a broad sense, the countries which seem to be closer to respect such requirements are Czech Republic, Poland and Hungary. The other countries have made substantial efforts indeveloping some of the key characteristics above mentioned, but they are at the beginning of the process. In particular, as it will become clear in the following pages, the biggest trouble is in the lack of the development of a full financial system, with short term, medium and long term interest rate actively managed and fully representative of the money market (or bond market) situation. The discussion about the characteristics of such countries different from the three leader countries form the subject of the following pages. As I said before, the main pre-requisite for a successful implementation of inflation targeting is given by a sound fiscal policy, as discussed by Leeper (1991), Sims (1994) and Woodford (1996, 2003). On the other hand, the magnitude of such deficit is mainly temporary and also the market understood that the magnitude of such deficit is not so high to prevent the operating of a good inflation targeting policy. An important element in this context is represented by the fact that after joining EMU, accession countries will be forced to adopt the Stability and Growth Pact, which is going to push all of them to adopt a sound fiscal position. Among the various pre-requisites for inflation targeting policies mentioned before, probably the more difficult to be fulfilled is given by the limited ability from Accession Countries Central Banks to have a good ability in forecasting the inflation rate. This is an important point, as discussed in fact by Svensson and Woodford (2003) and by Svensson (2003), especially if we think that an inflation targeting policy is obtained necessarily over a period of two- years length, making the intermediate inflation targets as forecasted inflation targets. Therefore, if the ability in targeting the quarterly inflation rate is scarce, there might also be strong consequences in fulfilling the long term target, too. The scarce ability in realizing a sound expected inflation targeting is in fact one of reasons of the large undershooting and overshooting phenomena of the inflation swings characterizing such countries.
  32. 32. 3. The Czech Republic The Czech Republic was the first country among the Accession Countries in implementing the inflation targeting policy, after the currency turbulence of 1996/1997. The fear of the inflation expectations raised immediately after the currency devaluation in 1996 pushed the Czech National Bank to adopt a strong inflation targeting procedure which was announced in December 1997. In the announcement made by CZ monetary authority it was made clear that the Central Bank chosen to target the inflation rate with a band of one percentage point - widened to 2 percentage point in 2000 – rather than targeting a single pointwise value. The inflation to be targeted has been chosen to be computed on the basis of the CPI (Consumer Price Index) changes, excluding the contributions coming from changes in regulated prices. This number was further adapted to take into account changing in indirect taxes or subsidies. As it will become clear later, the type of inflation rate is crucial because this can generate a very imprecise estimation of the expected inflation rate and a missing the targets of the inflation rate target over several periods. As it will described later, the missing of the inflation rate has forced the CNB to introduce some exceptions that could justify the missed inflation targets. Among such exceptions, the CNB listed significant differences between actual and predicted exchange rate that do not reflect the development of domestic monetary policy and significant changes in the agricultural products. It is also worth to note that in December 1999, the Czech National Bank has adopted long term inflation targets for 2005. Undoubtedly, this had the effect of involving the public in the process of evaluating the performance of the policy effect. At the same time, given the strong impact on the level of aggregate output and employment, the CNB announced that the long term target, together with the speed of the disinflation process had to be considered jointly together with a Governmental decision. A final modification of the inflation targeting procedure occurred in 2002 when the Czech National Bank announced that it will target the headline of the CPI, in order to be more able to affect inflationary expectations.
  33. 33. It is now worthwhile to analyze some of the characteristics of the time series for a group of selected variables for Czech Republic. The CR is characterized by a relatively high degree of development of the domestic financial market, if compared with many other accession countries. This is also proven by the existence of several time series for the money market interest rates. In Table 1 I collected some statistics about selected variables Table 1. Statistics for selected variables of Czech Republic Sample 1994:1-2003:4, monthly obs. Mean St. Dev. Skewness Kurtosis J.B. Interest Rates 1 day 14 days 1 month 2 months 3 months 6 months 9 months 1 Year 1 month Treasury Bill Ret. 3 month Treasury Bill Ret. 9.03 7.32 5.88 48.11 11450.2 9.16 5.48 2.31 10.11 577.82 9.11 5.018 1.47 4.41 131.66 9.05 4.72 1 1.89 35.43 9.018 4.52 0.7 0.54 4.98 8.94 4.27 0.4 -0.65 5.03 8.94 4.16 0.31 -0.85 5.13 9 4.124 0.26 -0.87 4.88 9.088 4.98 1.5 4.59 140.57 9.011 4.49 0.66 0.39 8.99 Inflation Rate (CPI-based) 5.53 8.11 2.29 8.29 415.38 Growth Rate of Monetary Base Growth Rate of M1 Growth Rate of M2 7.46 12.86 0.27 -1.05 5.92 7.59 8.15 -0.98 -0.12 16.1 9.45 5 1.05 0.01 18.52
  34. 34. The numbers reported in the above table refer to the sample 1994:1- 2003:4. All the data were collected on a monthly basis, by mixing up the information obtained from Datastream and from the Website of the Czech National Bank (CNB, henceforth). A positive aspect is given by the high number of short and long term interest rates: this is a sign of a good and well developed financial market. In Table 1 I reported the Mean, the Standard Deviation and Skewness and the Kurtosis index for each time series. I also reported a preliminary test of normality according to the procedure described by Jarque and Bera, indicated in the table with J.B. Recall for completeness that the Jarque and Bera test is distributed with a chi-square distribution with two degree of freedom: at 5% the value of the distribution is 5.99. All the interest rates reported in the Table 1 are money market interest rates. According to the numbers reported in Table 1, we find that the more volatile interest rate is given by the short term (one day) interest rate, while that more stable interest rate is given by the one year money market interest rates. It also worth to note that shorter is the maturity, and higher is volatility and the skewness and the kurtosis. In fact the one day interest rate is far from being normal, given the high value assumed by the skewness and the kurtosis. This is also confirmed by the values of the Jarque and Bera test given by 11450.2, which is largely bigger than the critical value. The distribution of the short term interest rate is far from being normal. Things are different, for money market interest rate for longer horizon: in particular, from the three-months interest rate, as well as the six, nine months and one year interest rate we get low volatility and full normality. From Table 1 we also get that the Government bond treasury bill are also far from being normal. Also the inflation rate is a non-normal process (the J.B. test is 415.38), and the standard deviation is 8.11. Over the full sample we observe that on average the nominal interest rates are higher than the inflation rate. However, the inflation rate is very volatility if compared also the nominal interest rate. Finally, the growth rate of money aggregates over the sample has been quite high (surely higher than the requirement prescribed by European Central Bank): only monetary base growth rate shows to have a fully normal distribution.
  35. 35. To have an idea of the development of the variables over time, we can also have a look at Figure 1, where I represented the revolution pattern of the growth rate of M1 and M2 over time, since the beginning of the sample. It is interesting to note the very strong monetary restriction occurred since may 1997, when the growth rate of M1 became negative. We can also observe that the money growth rate in the following periods is continuously increasing. The strong contraction of money supply is due to the strong currency crises experienced by Czech Republic in 1997: the monetary contraction is the natural consequence of the initial of an inflation targeting procedure in the management of monetary policy. The presence of the currency crisis in the data can be also recovered in Figure 2, where reported the evolution pattern of two interest rates: the one day and the one month inters rates: from Figure 2 we observe the high peak observed by both interest rates, when in July 1997 the one-day interest rate reached 71 per cent and the one month peaked at 41 per cent, in order to contrast speculative attack on the currency. If we represent the nominal rate after the implementation of the inflation targeting we observe, instead a steady pattern converging towards low values, starting from 1998, as reported in Figure 3, where I represented the one day interest rate, the 6-months and the one year interest rates: they tend to show very strong and interrelated co movement. The lines reported in Figure 3 start from January 1998, after the introduction of the inflation targeting procedure in Czech Republic and after the currency crisis. Like all the other Accession Countries, the adoption of a strict inflation targeting policy can be a source of several problems, especially on the side of volatility of output and interest rates. As a general judgment, we can say that the main problems experienced by such countries derive just from the fact that the Czech National Bank decided very strong adherence to the inflation targeting principle, without considering a more flexible approach as described by Svensson and Woodford (2003) and Svensson (2003).
  36. 36. In general, inflation targeting procedure can be evaluated under two aspects: in terms of the adherence of the actual inflation targets to the forecasted targets and in terms of their ability in keeping under control the level and especially the volatility of the inflation rate, output and the interest rate, in order to avoid the unpleasant consequence of instrument instability. From what concern the first aspect, I reported in Table 2 both the targets and the actual values forthe inflation rate. Table 2. Target and Actual inflation in Czech Republic Target Actual 1996-1997 1999 2000 2001 2002 5.5-6.5 8.2 4 - 5% 2 3.5 - 5.5 3.85 2 - 4 % 4.11 2.75 - 4.75 0.54 From the above table we see that CNB understate very much the inflation rate during the past years. To understand the reason behind this, we can focus on two crucial aspects: (i) business cycle fluctuations; (ii) technical difficulties in targeting inflation, or a proper measure of it, as discussed by Svensson and Woodford (2003) and Svensson (2003) . The first set of reason, due to business cycle fluctuations has to do with the difficult structural situation characterizing the Czech Republic during the transition period. This is strictly linked to the second aspect, i.e. the difficulty in adequately forecasting the inflation rate. This is mainly due to the different definition of the inflation: initially, the inflation was measured as the rate of change of domestic price level, net of controlled prices. Since the economy was subjected to a substantial amount of controlled price level, it is clear that the actual inflation rate is lower than the estimated one. In particular, when inflation targeting was introduced, the inflation rate was high. In the subsequent years, during the occurrence of a banking crisis, the economic activity experienced a long recession, making the inflation rate to decrease substantially. At the same time, the large capital inflows due to the large amount of foreign investment contributed to an appreciation of the exchange rate and to a worsen of the economic situation.
  37. 37. Although the strong reduction of the inflation rate can be considered as a clear success, we need to ask if this result was obtained efficiently or not, i.e. by avoiding to have an excessive volatility of the interest rate, usually referred as instrument instability, or of output. To understand this, I reported in Table 3, the mean and standard deviations (s.d. in the table) of some selected variables over two subsamples. The first subsample is preliminary to the introduction of the inflation targeting, while the second includes the full inflation targeting period. From the numbers reported in Table 3 we find that after the introduction of inflation targeting we observe a strong reduction of the inflation rate in the second sub sample where the inflation rate dropped from an average value of 8.35 reported in 1994-1997 to 3.5 per cent in 1998-2002, at the expenses of an increase of its volatility going from 6.9 per cent to 8.35 per cent. At the same time, all the sequence of interest rates (both short and long term) shows a marked reduction passing from a crawling peg regime to inflation targeting regime. This, however, did not properly imply an increase of the volatility of the nominal rate over time. In fact, the short term interest rate do not show instrument instability phenomena. Only medium term interest rates (3, 6 months, one year and 3-months Treasury Bills) show the instrument instability phenomena. Finally, the behavior of monetary aggregates show a contradictory phenomena: after the introduction of inflation targeting, M2 shows a strong reduction right after the introductionof the inflation targeting regime. However this was partly counterbalanced by an increase of M1 in the last part of the sample: in this period, CNB tried to keep under control M2, releasing the control over M1, in order to limit the negative consequences of the adoption of inflation targeting on the level of output. For what concerns the speed of the disinflation process, Czech Republic, opted for a fast path. In fact, immediately after the introduction of the inflation targeting regime, the inflation moved from 8.2% on average computed over the sample 1996:1-1997:11, to 6.52% in 1998.
  38. 38. This reduction of the inflation rate continued also in the following years: in 1999 the inflation dropped further until 2%. Since then the inflation remained well below the values assumed in the period 1996/1997. From one side, the strong reduction of the inflation rate can be viewed as a clear success of CNP. On the other hand, the strong reduction of the inflation rate coupled to the difficulties experienced on the demand’s side posited a large pressure on the Czech National Bank form the political authority’s side. In fact, although the independence of Czech National Bank is guaranteed by the Constitution, in 2002 the Act of the Constitution of Central Bank was amended by including the qualifications that the goal of maintaining price stability should be accompanied to support Government policies aiming to lead to a sustainable growth. In a broad sense, this amendment can be interpreted as a slight reduction of the degree of independence of the Czech Central Bank. Table 3. Statistics for selected variables of Czech Republic for two distinct sub-samples, monthly obs 1994:1 - 1997:11 1998:1 - 2003:04 Growth Rate of M1 Growth Rate of M2 mean s.d. mean s.d. 4.91 9.28 7.69 7.9 13.46 7.27 5.94 2.55 Interest Rates 1 day 14 days 1 month 3 months 6 months 1 Year 1 month Treasury Bill Ret. 3 month Treasury Bill Ret. mean s.d. mean s.d. mean s.d. mean s.d. mean s.d. mean s.d. mean s.d. mean s.d. 12.32 6.56 9.45 3.66 12.4 6.73 5.65 3.89 12.15 6.75 4.56 3.94 11.9 6.77 3.27 3.97 11.71 6.78 2.61 3.95 11.73 6.86 2.14 3.9 12.15 6.7 4.55 3.84 11.88 6.77 3.19 3.97
  39. 39. Inflation Rate mean s.d. 8.35 3.45 6.9 8.35 In fact, the too fast disinflation process created several tension in Czech Republic: the undershooting of the inflation rate caused economic growth to become negative. After a change in the government ‘s guide occurred in mid 1998, when the President of CNP became Prime Minister, and after an electoral campaign where party formerly leading the country lost the elections, the Central Bank was considered responsible for the large economic downturn and implicitly for the electoral loss. This brought to consider the degree of independence of CNB no longer sustainable. After several struggling between the Government and IMF and EU/EMU, which requires an independent central bank as a prerequisites to EU Accession, the CNB retained its independence, but not completely, as explained before with the introduction of the 2002 Act. To sum up, the speed of the disinflation process shows that a too fast reduction of the inflation rate can create the risk of tensions between Government and Central Bank, leading to a loss of independence of Central Bank. It is always true, however that the external constraint – personified by IMF and EU Accession requirement rules – acts as a break with respect to the temptation expressed by the Government to affect central bank actions. 4. Poland The introduction of an inflation targeting procedure began in Poland in 1998. Before that date, Poland was under a crawling peg regime and experienced a strong real currency appreciation and a progressive widening of the nominal exchange rate band up to 15%. The introduction of inflation targeting in Poland was accompanied by the insertion of some rules forcing the National Bank of Poland (NBP,. henceforth) to adopt economic policy initiatives in support of the Governmental Action. The inflation rate to be targeted by Poland Central Bank is represented by a specific range which was initially set to be 0.5%, but later was widened to 1.2%. One of the main troubles of NBP in achieving a successful inflation targeting without too large undershooting and overshooting was represented by a lack of a clear set of exceptions that have to be taken
  40. 40. into account if the target is not satisfied.
  41. 41. The inflation rate in Poland has been defined on the basis of a broad Consumer Price Index: the NBP stressed very much that fact that targeting a different measure of the price index will not lead to a correct measurement of the inflation, because it would necessarily exclude some components, like administered prices, that form an important basis for having a correct representation of the inflation rate. In Table 5 I reported the value of some selective statistics for two crucial variables: the three-months money market interest rate and the inflation rate in Poland for three time horizon: the Full sample ( 1997:1 – 2002:12), the period preceding the introduction of the inflation targeting (1997:1 – 1998:7) and the last sample period covering the full inflation targeting period5 (1998:9-2002:12). Table 4. Statistics for selected variables of Poland for two distinct sub-samples, monthly obs Mean St. Dev. Skew. Kurt. J.B. All Sample 1997:1 - 2002:12 3 months int. rate Inflation Rate 17.19 5.28 -0.21 -0.79 2.41 6.64 7.47 0.73 2.22 21.03 1997:1 - 1998:12 3 months int. rate Inflation Rate 22.51 2.44 9.12 8.65 1999:1 - 2002:12 3 months int. rate Inflation Rate 14.53 4.05 -0.44 -1.03 3.7 5.48 6.42 0.135 -0.35 0.39 From the numbers reported in the Table 4, we realize that after the implementation of the inflation targeting we observe a strong reduction of the average inflation and nominal interest rates. It is also easy to note that the volatility of the inflation rate became slightly lower than before.
  42. 42. Another element which is worth to be stressed out pertains to the change in volatility of the nominal rate employed in the analysis: after the introduction of inflation targeting, the volatility of nominal interest rate has increased a lot, if compared with the previous sample period, moving from 2.44 per cent to 4.05 per cent. Evidently, this indicates that the introduction of inflation targeting in Poland caused instrument instability phenomena. In Poland, the decline of the inflation rate after the change in monetary regime was substantial. We can analyze the disinflation process by looking at the pattern described in Table 5, where I reported the target and the actual inflation over the years following the introduction of the inflation targeting regime. However, a more careful analysis of the disinflation path reveals that the reduction of the inflation rate in Poland was not so steady as it happened for Czech Republic. In fact, in 1999 the inflation rate increased passing from an average rate of 8% in 1998 to an average rate of 9.32% in 1999. Since then, the inflation rate started to decrease approaching a valued well below the long run target set out by the NBP. Table 5. Target and Actual inflation in Poland Target Actual 1999 2000 2001 2002 6.4 – 7.8% 9.32% 5.4 – 6.8% 8.31% 6-8% 3.57% 4-6% 0.72% From Table 5, we have the elements to judge the efficacy of inflation targeting in Poland. According to Table 5, we see that during 1999 and 2000 NBP the actual inflation rate overshoot the targeted values, while in 2001 and 2002 there was a clear undershooting of the actual inflation rate. It looks that NBP was not in the situation of achieving its goals in terms of inflation targeting. As a partial explanation of this situation, we can say that during the highlighted sample period, there have been a set of
  43. 43. remarkable changes in the structure of industry and business cycle. The increase of the inflation rate in 1999 and 2000 was mainly determined by a fast economic growth in domestic demand accompanied by an increase in import prices. It has to be remarked also, that the scarce success of the inflation targeting regime has also very much to do with the ability of NBP to set a credible inflation target. In fact, the central Bank of many accession countries does not always possess a clear situation about the true state of the economy of a specific country, because also of troubles in assessing data. The next question regards the costs of inflation targeting policy. In this case, I reported in Table 6 the output volatility here computed as the standard deviation of the Industrial Production Index, computed on a monthly basis. By comparing also the numbers reported in Table 5 about the volatility of inflation and nominal rates, we observe that moving to an inflation targeting regime for Poland has implied an increase in output volatility (the Standard Deviation of output moved from 6.46 in the sample 1997:1 - 1998:7 (preceding the inflation targeting rule) to 10.75% in the following period. Therefore, other than instrument instability, the policy inflation targeting lead the country also to experience an excessive targeting of the output. Table 6. Output volatility in Poland Period Output Volatility 1997:1 - 2002:12 1997:1 - 1998:7 1998:9 - 2002:12 12.65 6.46 10.75 Finally, in Table 7, I reported the evolution of the mean and the standard deviation of growth rate of monetary aggregates over the various samples considered in the paper: Monetary Base (MB), M1, M2, M3.
  44. 44. Table 7. Statistics for growth rate of monetary aggregates, Poland Growth Rate of Growth Rate of Growth Rate of Growth Rate of MB M1 M2 M3 1997:1 - 2002:12 1997:1 - 1998:7 1998:9 - 2002:12 mean s.d. mean s.d. mean s.d. 8.61 10.95 14.35 14.4 6.56 7.49 8.17 7.93 10.44 12.78 22.76 22.5 2.35 1.57 1.64 1.59 8.15 10.49 12.25 12.36 7.19 8.3 7.79 7.56 From the numbers reported in Table 7, we observe a substantial reduction of the growth rates of monetary aggregates in the sample period where the inflation targeting was implemented. This is a sign of a good control over monetary aggregates. Overall, the inflation targeting policy was not implemented without a cost. In fact, the strong reduction of the inflation rate accompanied by a downturn of the economy’s growth rate Output Period Volatility 1997:1 - 2002:12 12.65; 1997:1 - 1998:7 6.46; 1998:9 - 2002:12 10.75 generated several tensions between central Bank and the Government: the former was blamed by the latter for keeping interest rates too high. Such tensions led to create a pressure towards the reduction of the degree of independence of the Poland Central Bank, trying to include among his goals also economic growth and employment. In Poland the tension between Central Bank and the Government were also originated because of the attempt of NBP in trying to force the Government to adopt a tighter fiscal policy. The risk of this was hat Central Bank acted as an antagonist with respect to the Government in the implementation of policy initiatives: this induced a sort of retaliation with the attempt to reduce the degree of independence of Central Bank.
  45. 45. Even for Poland, we observed a common phenomena occurring in many other central banks of accession countries: the changeability of roles between central bankers and politicians: in 2001 the NBP president Leszeck Balcerowicz was a former politician. A key element to introduce goods stabilization plans is given by strong separation between the roles of politicians and central bankers, in order to avoid credibility crises. 5. Hungary The introduction of the inflation targeting for Hungary occurred quite in late if compared to the Czech Republic and Poland cases. In fact, even Hungary started the transition by adopting a currency peg against a based of currencies, with a fluctuation band of ±0.5, successively widened to ±2.25 percent. The period 1995-1999 was characterized by strong capital flows and currency appreciation. This helped the National Bank of Hungary (NBH) to keep under control the inflation rate by using the exchange rate as a nominal anchor. This task was made easier by the presence of capital control over short terms capital flows. However when domestic factors created the condition for the inflation to raise again, in order to reduce the pressure on exchange rates, the Central Bank accepted to cut interest rates. The result was that the exchange rate started to depreciate, but inflation did not reduce at all, even because the growth rate was high, as well as domestic demand. During 2000-2001 the strong tendency towards the appreciation of the exchange rate was mitigated by sterilized intervention. When the cost of such interventions became too high, in May 2001 Central Bank decided to widen the fluctuation band of the exchange rate, but in October 2001 NBH decided to adopt flexible exchange rate by the introduction of the inflation targeting regime. However, this change of the monetary policy regime was not clearly announced and it remained confused. The formal statement of the change in policy regime occurred with the emanation of an act on the National Bank of Hungary defining its main task the goal of maintaining price stability. In August 2001 NBH officially announced the starting of the inflation targeting regime, as explained in the inflation quarterly report.
  46. 46. As Czech Republic, Hungary adopted a fluctuation band of ±1 percent tolerances around the announced disinflation path. Let us consider now some basic statistics for Hungary as reported in Table 8. Table 8. Statistics for selected variables of Hungary for two distinct sub- samples, monthly obs Mean St. Dev. Skewness Kurtosis J.B. Interest Rates Short Term 3 months 6 months 1 Year 3 Years 5 Years 13.97 4.69 0.26 -1.28 6.04 13.27 4.37 0.3 -1.12 5.08 13.24 4.36 0.33 -1.16 5.67 13.16 4.38 0.33 -1.22 6.14 12.07 3.93 0.38 -1.37 7.75 11.18 3.6 0.47 -1.28 7.94 Inflation Rate (CPI-based) 9.31 7.78 0.72 1.27 11.71 Growth Rate of M1 Growth Rate of M2 Growth Rate of M3 16.93 4.01 0.84 1.2 11.2 13.33 3.26 -0.61 -0.63 5.055 13.9 3.03 -0.64 -0.68 5.59 From the numbers in Table 8 we observe that the series of nominal interest rates share means in the same range. Overall, the data generating process of the interest rate time series does not seem to have a normal distribution. In fact, for the short term interest rate, the one, three, five, years interest rates the Jarque Bera test reject the hypothesis of normality at 5%.
  47. 47. The inflation rate is also characterized by high standard deviation and by high values for the Jarque Bera test. Among the growth rates of monetary aggregates, the growth rate of M1 is theonly one which shows values high values for skewness and kurtosis, as well as for the Jarque Bera test. Let us look now how the central Bank in Hungary was able to keep under control the inflation rate, by achieving the targets announced. Recall that the policy of inflation targeting for Hungary has been launched only in mid 2001. When inflation targeting was set, the inflation rate was declining and the effects coming from nominal exchange rate targeting were strong. In table 9 I represented the discrepancy between Actual and Targeted inflation rate. Table 9. Target and Actual inflation targeting in Hungary Year Target Actual 2001 2002 6 - 8 per cent 6.63 per cent 3.5 - 5.5 per cent 4.8 per cent From Table 9 we observe that Hungary centered the inflation rate almost perfectly over the various sub-samples. Let us consider now in Table 10 the evolution of the variables in the two subsamples: one without inflation targeting and the other with inflation targeting
  48. 48. Table 10. Statistics for selected variables of Hungary for two distinct sub-samples, monthly obs 1997:1 - 2001:07 2001:9 - 2003:04 Growth Rate of M1 Growth Rate of M2 Growth Rate of M3 mean s.d. mean s.d. mean s.d. 16.25 18.06 3.15 5.08 13.1 13.76 3.88 1.33 15.42 10.68 1.89 2.49 Interest Rates Short Term 3 months 6 months 1 Year 3 Years 5 Years mean s.d. mean s.d. mean s.d. mean s.d. mean s.d. mean s.d. 15.94 8.78 3.98 1.36 15.08 8.5 3.71 1.47 15.04 8.53 3.75 1.37 14.96 8.45 3.8 1.3 13.62 8.035 3.52 0.99 12.58 7.52 3.26 0.73 Inflation Rate mean s.d. 11.01 5.28 7.78 1.36 As before, the dataset includes variables for Hungary running from1997:1 until 2003:04, monthly observations. The sample period is divided up into two subsamples: the first from 1997:1 to 2001:07 corresponds to the period without the inflation targeting, while the second subsample going from 2001:9 until 2003:04 corresponds to the period where Central Bank of Hungary adopted the inflation targeting. I left out the period of August 2001 when was released the official announcement of inflation targeting period
  49. 49. in Hungary. From the numbers reported in Table 10 we have that after the introduction of inflation targeting policy the mean and variance of all the variables dropped considerably. In particular, the extent of the reduction of the inflation rate was quite remarkable: the inflation rate in the second subsample was half of the inflation rate recorder in the first, without inflation targeting. The only exception to this is represented by M2 and M1: their mean increases from the first subsample, to the second subsample, as well as their volatility. The sharp reduction of the inflation rate and the strong control over M3 – the monetary aggregate crucial for joining the European union – are an explicit signal of the fact that the implementation of the inflation targeting strategy sorted out good results in Hungary. It is certainly true that the sharp reduction of the inflation rate cannot be considered as the unique results of the implementation of inflation targeting policy. It is worth to mention the important role of the nominal exchange rate appreciation in the disinflation process. We can also visualize these effects by observing the pattern of some variables reported in two pictures. In Figure 4 I represented the pattern of the Hungarian Interest rates over the sample period. From this figure we observe two crucial facts: first, the interest rate show a constant, steady reduction over time. Secondly, all interest rates seem to be characterized by a common set of factors. This can be seen by the fact that we do not observe significant differences among the pattern of the interest rates.
  50. 50. 6. Inflation Targeting: A Preliminary Assessment The role of inflation targeting in accession countries raises several additional issues. In hat follows I am going to concentrate no two specific questions: (i) should a transition economy e more concentrate in targeting a pointwise value or a range of values for the inflation rate? Secondly, what kind of initiatives should be implemented when the actual inflation differs from the argeted disinflation path ? ehind these aspects, there are many other additional issues that I am not going to touch in his work. Just to mention one of them: the type of price level to be targeted, in forming the nflation rate. This issue is crucial for Eastern European Countries where still many prices are regulated. Probably, the best measure of the inflation rate to be targeted is the headline inflation rate, measured s the rate of change of the Consumer Price index, instead of considering a measure of the inflation computed net of regulated prices. In fact, a price including also induces Central Bank to adopt a too tight monetary policy. With respect to the issue concerning the point vs. target issue, we can start by saying the targeting a point can be seriously dangerous for the credibility of the central bank. In fact, all the troubles come when this pint is not respected: this could generate several pressure on the central bank that could force the president to resign and to limit the degree of independence of the central bank. A related problem has to do with the timing of the disinflation process. As discussed by Svensson (2003) the time horizon for the inflation forecasts targeting should be no
  51. 51. shorter than two years. In fact, it has estimated that the lags from monetary policy actions to inflation are in general estimated to be of 2 years. A too short horizon could imply several misses of the inflation target, together with the risk of having instrument instability, and excessive output fluctuations. Such type of risks are more pronounced if we consider a small open economy where exchange rate fluctuations can have a stronger impact on the domestic inflation rate, causing an excessive reduction of the inflation rate. The two-year target implies a more gradualist approach in the disinflation path, without creating excessive output fluctuations. The next question is related to the fluctuation of inflation around its target. From the experience of Poland, Hungary and Czech Republic it appears that all central banks have treated the ceiling and the floor of the inflation targeting range quite differently. If the inflation rate is above the target, the central bank can induce a strong reaction of nominal rates to curb the inflation rate. On the other hand, the undershooting of inflation below its target can create an opportunistic behavior form the central bank in trying to lock in the inflation rate in a low level. If this is the strategy preferred by Central Bank, it must evaluated also against the costs in terms of both credibility and output fluctuations. The analysis of the influence of the exchange rate in the experience of transition economies should be carefully examined, given its strong influence on the pattern of monetary policy conduct. Of course, the effectiveness of the exchange rate channel has to do with the degree of opened of the economy under analysis. In particular, Czech Republic and Hungry are very open economies, because the share of exports plus imports amount to more than 100 per cent of GDP. The role of exchange rate in the case of accession countries appears to be crucially important for two additional reasons: (i) the fact that during the ERM2 stage the exchange rate will be fixed against the Euro; (ii) transition economies often borrow in foreign currency denominated bonds or loans. For all these reasons, it seems natural to have a monetary policy high concern towards exchange rate fluctuations, which in some cases can push central bank to focus excessively on short term horizon.
  52. 52. Potentially, this situation can lead to instrument instability and excessive volatility of the real exchange rate. In general, the fluctuations of the exchange rate depend very much in the type of shocks hitting the economy during the transition phase. In this context, the large part of transition economies have to deal with a convergence plan which help to reduce the currency risk premium, as a first effect. During this period, it is then frequent to observe a currency appreciation, as the result of an international portfolio reallocation towards transition economies, because of both FDI (Foreign Direct Investment) and capital flows due to privatization process. Such situation can make the task of leading monetary policy even more difficult. Things go well if the currency appreciation turn out to be not excessively strong and the growth rate of output is not affected too much by this: in this case, central bank can keep under control the inflation rate. However, if currency appreciation is too fast, it becomes largely advisable to manage a slow reduction of the nominal interest rate, together with a combined set of sterilized intervention in order to keep the exchange rate under control and minimize the impact on the corporate sector. It should also be stressed out that a too sharp currency appreciation can generate high current account deficits which in the medium run might induce a currency depreciation, which should be strongly avoided in order to prevent a financial crisis induced by the deterioration of the balance sheets. To sum up, in accession countries there might be the need to mix together the concern towards inflation rate and the exchange rate, by taking into serious account the risk of generating strong impact on the aggregate activity.
  53. 53. 7. Targeting Rule: A General Approach According to Svensson (2003), and Svensson and Woodford (2003), the concept of monetary policy rule should be intended as a simple "prescribed guide for monetary policy conduct". Under this view, the definition of monetary policy rule should be broadened. Before make any progress on this subject, it is worth to mention some specific terminological aspect. First of all "target variables" are the operational goals and they represent the variables which enter into a loss function. A general targeting rule is a specification of a monetary policy rule that specifies, the operational objectives (the target variables), the targets (the specific values for the target variables) and the loss function to be minimized. A specific targeting rule is a definite operational condition for the target variables, or their forecast. The role of forecast targeting consists in considering as operational objective the forecast of a specific variable. This also implies that such variable should enter as argument into the loss function. The basic ingredient to perform this exercise are: a quadratic intertemporal loss function; a set of additive future uncertain variables. In this case, monetary policy makes conditional mean forecast of the future target variables, conditional to information available to central bank ina given, specific moment about the current and the future state of the economy. The steps are as follows: (i) compute conditional forecasts of inflation and output gap, conditional on different paths of the central bank's instrument rates, by using the relevant information about the current and the future state of the economy; (ii) raise the instrument path is the inflation forecast is too high relative to the inflation rate at the relevant horizon; (iii) Update the problem if new significant information has arrived. Therefore, a commitment to a general forecasting targeting rule means a commitment to minimize a loss function over the forecasts of the target variables. The result from this optimization process is a decision function relating the operating instrument to the central bank's information set. The first advantage of this type of monetary policy rule is given by the
  54. 54. fact that central bank is forced to clearly specify the goals via a proper specification of the loss function. This allows to use a discretionary approach in the choice of the targets, but not with respect to the ultimate goals. This is a remarkable achievement. A further advantage is given by the flexibility of this approach: in fact central Bank can make herself ready to react to the unforecastable events without loosing credibility, by using extra model information. A final, more foundational reason about the missing targets of the accession countries is because under a variety of shocks and turbulence, like that occurred in those countries during the past years, the monetary policy rules adopted by those countries can be though as obtained from a discretionary optimization. We have seen that with a forward looking behavior, the minimization of a loss function does not deliver an efficient response to the shocks. This is because of the lack of history dependence. In fact, via history dependence the central bank can adjust the short run trade-off according to private sector expectations, according to the pattern of past shocks: this in fact ensures a better ability to determine the evolution of the economy that people was expecting. This is just the result of discretion: central bank does not care about the past, because the past does not act as a constraint for the future. 8. Concluding Remark In this contribution I examine the impact of inflation targeting in the macroeconomic performance of three Accession countries. The analysis is conducted by examining recent data sets and by comparing the results and the experience of these countries with the prescriptions coming from recent contributions in Monetary Theory. The introduction of inflation targeting in such countries fulfilled to goal of reducing the inflation rate. However, the main conclusion is that: (i) in some cases (Czech Republic and Poland) there is a marked undershooting of the inflation rate with respect to the target; (ii) the cost of disinflation cast some troubles in the attempt to keep central bank independence. Some proposal to amend the actual monetary regime with additional ideas are made. The analysis needs to be extended by estimating a monetary policy reaction function of also the other accession countries that plan to join EMU.
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